The Case for California Defaulting, Even If It Won’t

The State of California is having another horrible week. This one started with the legislature missing Monday’s deadline for a new budget to be submitted — a deadline that laughably ungovernable California has dutifully missed every year since 1986 — and it continued with S&P putting the state on credit watch for a possible downgrade.

Bill Lockyer, the state’s treasurer (sic.), ignored the former news, but, via his spokes-thingie, went bat-shit nuts at the latter development. Why? Because he knows there is precisely zero chance the state’s on-beyond-incompetent legislature will entirely close California’s $24-billion and growing budgetary deficit. At best we might see it halved through cuts, a goodly chunk of which will be phantom and/or punts to the future. So that means Treasurer Lockyer must make up the difference with Other People’s Money, which puts him on the bond-flogging trail sometime this summer. That will be at higher than usual higher yields, but not nearly so high as yields would be if S&P followed through on its threat and downgraded California’s droopy, A-rated GO bonds.

The root issue, of course, is that California is insolvent, and irritating people like S&P analysts keep noticing. The state — let’s call it Latvia by the Pacific — has a $24-billion budget gap that must be closed for it to continue operating (and I use that word advisedly). Without a clear sense of how that will happen rational creditors are going to be increasingly skittish about filling the hole. Now, does that mean California can’t sell enough bonds to backfill the gap this time? You bet it can, and it will. This is part Schwarzenegger/Lockyer Financial Theater, and partly a laughably transparent attempt to demonstrate budgetary semi-competency in hopes of a few basis-points of relief on the inevitable bond sale. That’s all.

Because California has $5.7-billion in debt servicing obligations. And while that will grow, debt occupies pride of place in California’s constitution — only education must be paid off before the next slug of cash goes to creditors. Get that? Healthcare, prisons, and other frivolities can all go to rack and ruin, but creditors must be paid, constitutionally speaking. That means, if you’re looking at this through the gimlet eyes of muni-bond ghouls, that California has something like $50-billion in budgetary space to make its $5.7-billion in payments. It’s pretty easy to calculate that California can make the payment nut, even if it has to close hospitals, release prisoners and stop patrolling the highways to do it.

And that’s the problem. Because while California won’t default, at least not right now, for practical purposes it should. Its income and expenses are structurally out of whack, not merely temporarily so. The imbalance is an artifact of a bygone era, one that won’t come back any time soon — perhaps not in our lifetimes. So, default. Say "whoops", financially speaking, and bite it. Better now than later. But California can’t. It operates at the mercy of its creditors, and when this bit of theater is over said creditors will buy more debt, and California will keep making payments on it, right up until it can’t.

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More musings here from Bond Buyer.

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